What will happen when US stock regulators check Chinese firms - Paul Gillis

Paul Gillis

US legislators might support a bill to force Chinese firms listed in the US to let the US stock regulators, The PCAOB, check their files. But those checks will not prevent frauds like those by Luckin as some US senators claim, warns audit expert Paul Gillis on his weblog Chinaaccountingblog. Some predictions on what will happen after the bill has been adopted.

Paul Gillis:

EY in China is not inspected by the PCAOB. Would a PCAOB inspection have stopped the Luckin fraud? No, PCAOB inspections are after the fact, and EY had already discovered the fraud. Additionally, the PCAOB is not going to inspect every audit, but rather a selection of them and there is no guarantee that Luckin would ever have been inspected. Would EY have audited Luckin differently had it been subject to PCOAB inspections? Possibly, but I think that is unlikely. The Big Four member firms in China are not subject to PCAOB inspections but are regularly subject to inspections by teams from their own networks. While self-inspection is never as effective as independent inspection, I believe that the auditing culture of these firms has been effectively implemented in China, and that inspections would provide for a marginal increase in quality but would be unlikely to prevent future fraud. I believe that PCAOB inspections are useful, but the threat of inspections and the existence of inspections elswhere in the world has already brought those audit  practices to China. The bigger problem for the firms is a shortage of experienced partners – who are sometimes called the no hair/gray hair partners. The firms have been recruiting and auditing in China since the early 1990s, but the firms only became large in the early 2000s. Given it takes 15-20 years for an accountant to make partner in these firms, and another five before they are ready to serve as engagement partner on public companies, the firms are seriously short of highly experienced partners. Partner/staff ratios are completely out of whack for the Big Four in China. For example, PwC reports 720 partners and 20,000 staff in its China firm (which includes HK, Taiwan and Singapore) for a partner/staff ratio of 27.8. The US firm of PwC has 3,249 partners and total staff of 30,000 for a partner/staff ratio of 9.2. While I would not argue more partners means higher audit quality, the difference between the two staffing models is too extreme. 

I believe that this legislation will pass but China will moot it by agreeing to some form of inspections. The sticking point is likely to be state secrets. China will want to vet the working papers to make certain no state secrets are inadvertently disclosed. China does not seem to have focused on the fact that many audit partners are foreigners and the internal inspection teams include foreigners who see these state secrets.  Auditors should cooperate with regulators to minimize the presence of state secrets in working papers. I call for joint training sessions between auditors and regulators to determine what must be in working papers and what should not be recorded. I expect that most of China’s concerns can be alleviated if unnecessary state secrets are omitted from working papers in the first place.

More at the Chinaaccountingblog.

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The big four are back in China - Paul Gillis

Paul Gillis

The big four accounting companies - KPMG, EY, PwC, and Deloitte - are back in China, writes Beida accounting professor Paul Gillis at his website ChinaAccountingBlog. The method of counting market share has changed, but Gillis sees around 20% growth, he says.

Paul Gillis:

The rankings have changed quite a bit. The last two years have been very good for the Big Four, which have grown 20% while local firms experienced a minor decline in revenue of less than 1%. The Big Four share of the Top 100 market has grown from 27% to 34%, a remarkable reversal of the market share declines of earlier years. 

I believe that the poor performance of local firms can be explained by regulatory actions. Early in 2017 Chinese regulators shut down two of the largest local firms for several months due to audit failures.  Ruihua, which was ranked second in 2015 and which I thought might climb over PwC to first place, experienced a revenue decline of 29%. BDO, ranked third in 2015, slide to fourth with anemic revenue growth of 5%. While I support strict audit regulation, I fear that the Chinese system is unfair to large local firms that audit thousands of listed companies. 

For the first time, the CICPA has disclosed the split between audit and non audit revenues at the firms. The Big Four earn 84% of their revenue from audit while local firms earn 86%. Those ratios are much higher than accounting firms in other countries. The measures of market concentration reveal an Herfindahl-Hirschman Index of 498, higher than the two years ago measure of 444, but well below the 1500 typical of Western economies.

More at the ChinaAccountingBlog.

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How did the auditors deal with the ZTE scandal? - Paul Gillis

Paul Gillis

ZTE got itself into trouble by violating a ban on using American components for products it exported to Iran and North-Korea. The punishment - no US components for ZTE for seven years - might kill the Chinese companies, who cannot work without them. What did the auditors do, wonders Beida auditing professor Paul Gillis on his weblog.

Paul Gillis:

The ban came about as a result of ZTE violating the terms of a settlement agreement entered into as part of its 2017 guilty plea for conspiracy to sell telecommunications equipment to Iran and North Korea that included American components that are forbid for export to those countries. ZTE agreed to pay a fine of $892 million and be under probation for seven years. An additional penalty of $300 million was suspended provided ZTE complied with the terms of the probation, which it is reported included the requirement for ZTE to fire four top executives and discipline 35 other employees. ZTE did fire the top executives, but instead of punishing the other employees it paid them bonuses.   

ZTE was also required to undergo independent compliance audits related to its observation of export controls. 

Because ZTE violated the terms of probation they have been banned from acquiring US components (including the Android operating system) and presumably has to pay the remaining $300 million fine. ZTE admitted the behavior, but argues that the penalty is too severe and is trying to negotiate a settlement that would allow the company to survive. 

ZTE reports under Chinese accounting standards. Auditors Ernst & Young (EY) issued an audit report on the 2016 accounts on March 23, 2017. The agreement for the initial settlement became effective on March 22, 2017 and is reported in the 2016 accounts with the penalty of RMB 6.2 billion reported in other expense.  The company stated that it was unlikely they would violate the probation agreement and have to pay the other US$300 million. 

The details of when the bonuses were paid are publicly unavailable. Chinese companies usually pay bonuses at Chinese New Year, which was at the end of January in 2017 and in February in 2018. It seems most likely the offending bonuses were paid by February of 2018, before EY issued its audit report on the 2017 accounts on March 15, 2018. 

So what does this have to do with accounting?  The issue is whether EY should have known that there was serious doubt by March 15, 2018 as to whether ZTE could continue as a going concern. Should they have tested compliance with the probation agreement? 

In its audit report EY states its responsibilities as including to: 

Conclude on the appropriateness of the directors’ use of the going concern basis of accounting and, based on the audit evidence obtained, whether a material uncertainty exists related to events or conditions that may cast significant doubt on ZTE Corporation’s ability to continue as a going concern. If we conclude that a material uncertainty exists, we are required to draw attention in our auditor’s report to the related disclosures in the financial statements or, if such disclosures are inadequate, to issue a qualified opinion. Our conclusions are based on the audit evidence obtained up to the date of our auditor’s report. However, future events or conditions may cause ZTE Corporation to cease to continue as a going concern. 

EY did not draw attention in their auditor’s report to any events or conditions that may have cast significant doubt on ZTEs Corporations ability to continue as a going concern. I think there was information available to EY (the payment of bonuses in violation of the agreement) that should have led to its questioning the ability of the company to continue as a going concern. I believe that auditors rarely ask these questions, although if this were a loan agreement with covenants, I am quite certain they would have tested compliance with the covenants. 

The company got a clean opinion as of March 15, 2018, although only a couple of months later the survival of the company is in question. Should EY have blown the whistle earlier?

More at the Chinaacountingblog.

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